Pharmaceuticals: A reviving dose

Sanjiv Shankaran

PHARMACEUTICAL companies are emerging as the new hope for equity investors.

In a manner reminiscent of the information technology boom of 1998-2000, the growing US market and the potential it holds for Indian companies have triggered interest in pharmaceutical stocks. The upshot is that the valuation of pharmaceutical companies has improved significantly and seems set to continue.

The experience of the 1990s suggests that regardless of how plausible the reasons for higher valuations, it may be best to take them with a pinch of salt. What follows is an attempt to identify the factors driving the current pharmaceutical sector valuation and take a conservative look at their potential.

A heterogeneous industry

On occasions, high expectations and significant developments in top-rung companies eventually impacts the entire sector. The current situation appears to have triggered a rally in many low-profile pharma companies. Despite across-the-board activities, the focus ought to remain on the top-rung companies because they have set the trend.

Over the last 2-3 years, top-rung pharma companies have evoked considerable interest because of a unique set of factors -- their evolutionary path and the move to contain healthcare costs in the developed world.

Over the last 30 years, following amendments to Indian patent laws, Indian companies have developed expertise in inexpensively copying a drug protected by patents elsewhere. Simultaneously, the developed world has seen governments and insurance companies strive to contain healthcare costs. The aforementioned developments have now begun to overlap, thereby opening up new opportunities for Indian companies.

Another important development is that erstwhile equity market favourites, multinational companies, such as GlaxoSmithKline, Aventis Pharma and Novartis India have been marked down as they struggle to cope with a slowdown in domestic pharmaceutical growth.

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Therefore, the upward movement in equity valuation has really been restricted to a handful of Indian companies that have been able to sell their products abroad. MNCs have lost their sheen. A few lesser known companies, that are hoping to mimic the industry leaders, may also be on the verge of being rated higher.

Generics: Biggest driver of valuation

The single most important trigger for the upward movement in the valuation of companies is the expanding market for generics in the US. When it became apparent that realistic gains were possible for Indian companies in the US market for generics -- drugs that lose the monopoly provided by patents -- they received a huge boost.

The US is by far the largest pharmaceutical market in the world. To get an idea of its size, consider the following data. In the year up to August 2001, its market grew 16 per cent to record a turnover of $125.7 billion (IMS Health). For the same period, the combined growth and turnover of France, Germany, the UK, Italy and Spain were 9 per cent -- that is, $51.9 billion.

The US simply dwarfs everyone else. In that market, over $35 billion worth of drugs are going to lose the monopoly provided by patents over the next five years.

Success in the US generic market rests on two pillars: Effective process research skill and ability to meet their standards at a low cost. Just the ingredients the Indian market has helped companies absorb.

Generic formulations: The blockbusters

Loosely speaking, the generic market has two layers. The most lucrative one is the market for formulations (drugs in a ready-to-consume form). Formulations provide the best returns, but also involve the highest risk.

At present, only two Indian companies have made a big impact on the formulations market: Dr Reddy's Laboratories and Ranbaxy Laboratories. Of the two, Ranbaxy has been around in the US longer and is committed to building a big and diverse basket of drugs.

Dr Reddy's achieved noteworthy success recently through the launch of Fluoxetine (an anti-depressant) ahead of its generic competitors -- the first to launch makes the most.

Patent holders generally try to extend the life of the initial patent by using legal loopholes to get additional patents. The high-risk, high-return, generic formulation strategy is to challenge the patent holder. A challenge almost invariably leads to legal action and attendant cost. But if the challenger is successful -- as Dr Reddy's in Fluoxetine -- the returns are enormous.

Currently there seems to be only two companies in a position to play this high-risk game: Dr Reddy's and Ranbaxy. Both companies have shown the capability to manage the legal aspect, the process research skill and have the deep pockets that give them a fair share of success.

Of the other companies bandied about in this context, Wockhardt and Sun Pharmaceutical Industries, it may be prudent to wait for tangible evidence before placing them in the same category as Dr Reddy's and Ranbaxy.

Generic bulk drugs: Provide a steady return

Bulk drugs (active ingredient in formulations) are another route to tap the generic market. The returns are lower here because it means that the bigger risks are going to be taken by the formulator who gets the most out of the entry into generics. The positive spin-off of a bulk drug entry into generics is that the risks are lower.

A number of Indian companies participate in the bulk drug market, ranging from Dr Reddy's to Shasun Chemicals. The best returns in the bulk drugs market are likely to accrue to companies that manage to tie up a supply contract with a generic formulator that is in the process of mounting a legal challenge on the patent holder.

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Cipla is an example of a company that has sought to play this market. To illustrate, Cipla has an arrangement to supply bulk Omeprazole (anti-ulcer) to Andrx. Andrx is a generic formulator that has mounted a challenge on AstraZeneca, the patent holder for the popular Omeprazole brand, Prilosec.

To give an idea of the risk involved in this kind of method, consider the recent weak trend in Cipla's share price. Andrx was expected to get the go-ahead by the last quarter of the year, but the patent holder has managed to delay the launch. With the generic Omeprazole being an integral part of Cipla's equity valuation, a delay in the launch -- not totally unexpected -- led to a sharp reaction.

The less lucrative segment of the bulk drug generics is to enter into contracts with generic formulators when an attempt is not made to be the first to get in. In general, the bigger the basket of drugs that can be supplied, the better the chances of getting more such contracts. Therefore, it is important to identify companies that have the research skills and US regulator-approved manufacturing facilities as the most probable gainers.

Generics: Stick to facts

From a purely equity valuation perspective, generics-driven valuation is risky. A realistic appraisal of potential does not seem to have set in. It is still early days yet and there are bound to be exaggerated claims of companies' potentials and consequent volatility in valuation.

It may be prudent to stick to facts. Dr Reddy's and Ranbaxy are the most successful and look the likeliest to succeed in the near future. Cipla's process research skill and manufacturing strength make it the best placed to get the most out of the less lucrative segment of the bulk drug market. Currently, Cipla seems to have settled for a strategy that has a lower level of risk-and-return built in.

Sun Pharma and Wockhardt seem to be other companies equipped to do well in the generics. More achievements may be necessary in the case of these companies before one brings in generics in a big way into their valuation.

Research: Overstated?

Research and development is an integral part of the generics strategy. Without a threshold level of competence in R&D, a company is unlikely to make headway there. The number of companies that can do so are quite a few, but the ones that can add to their product basket regularly are limited. Shasun Chemicals, for instance, was one of the earliest to get into the US market, but product addition has been limited.

The other trigger for short-term rallies in stock price is any media report that a company has made significant progress in basic research. Just one out of a few thousand compounds developed actually enjoys some commercial success. That comes after years of work. Therefore, it may be safer to sit out research-driven rallies that can be sourced to the media and institutional investors.

In basic research, only Dr Reddy's has enjoyed significant monetary success. Ranbaxy has enjoyed significant success in research on more effective ways of delivering a drug to a patient -- an area that has interested many companies.

Indian companies need an external collaborator to handle clinical trials, the most expensive part of developing a compound into an approved drug. In the foreseeable future, all one can expect is a milestone payment when a compound clears a stage in clinical trials. The odds are certainly against the first few compounds developed by Indian companies becoming a roaring success.

Basic research has the possibility of throwing up a pleasant surprise. If one of the smaller companies can develop a promising compound that receives a couple of milestone payments, the company's valuation can undergo a sharp upward jump. For a small company, a milestone payment can unleash a chain of events that would lead to the big league and investors need to closely follow announcements of compounds being licensed abroad for clinical trials.

Valuation is still in a fluid state. It will perhaps become more volatile after Dr Reddy's unveiled amazing second quarter results earlier in the week. The profitability shot up after the company received approval for Fluoxetine sales in the US in August (after successfully mounting a challenge on the validity of the original patent, Dr Reddy's got a six-month monopoly on the 40 mg Fluoxetine).

Only a handful of companies is capable of living up to expectations. It takes just a couple of unexpected events for the valuation to be marked down suddenly. The technology valuation debacle suggests that it is time to be cautious about pharma valuations because within the next year, many of the companies may be marked down.